Chapter 05
Filing Requirements for Trusts and Gifts: Form 3520/3520A
If you have an interest in a foreign trust or received gifts from a foreign entity, you may be required to also complete Form 3520, Annual Return to Report Transactions with Foreign Trusts and Receipt of Certain Foreign Gifts and Form 3520A, Annual Information Return of Foreign Trust With a U.S. Owner. This is a form you need to file with your annual 1040.
International taxation is complicated and not for the faint of heart to try to decipher on their own. Even innocent errors can result in penalties and interest. In addition, the IRS is on the lookout for any activity that even hints of impropriety on behalf of the taxpayer.
This chapter is a continuation of the previous chapter on 1040s. If after reading this, you have any questions, then reach out to me and I or a member of my staff can walk you through completing Form 3530/3520A.
Step-by-Step Instructions
The instructions for Form 3520 specify who must file. See Internal Revenue Service Instructions for Form 3520. You are required to file the form 3520 if:
- You are deemed the responsible party for reporting a reportable event.
A reportable event is:
a. The creation of a foreign trust by a U.S. person
b. The transfer of any money or property, directly or indirectly, to a foreign trust by a U.S. person, including a transfer by reason of death. The penalty for failure to disclose the transfer is the greater of $10,000 or 35 percent of the gross value of the distribution received from or transferred to a foreign trust. See I.R.C. § 6677(a)(2). The failure to report foreign gifts can result in a 5% monthly penalty for every delinquent month up to 25%. See 26 U.S. Code § 6039F (c)(1)(B).
See Instructions for Form 3520 (2020), Penalties.
c. The death of a citizen or resident of the United States if the decedent was treated as the owner of any portion of a foreign trust, or any portion of a foreign trust was included in the gross estate of the decedent - You are a U.S. person who, during the current tax year, was treated as the owner of any part of the assets of a foreign trust.
- You are a U.S. person who received, directly or indirectly, a distribution from a foreign trust (including uncompensated use of trust property) or a related foreign trust held an outstanding obligation issued by you that you treated as a qualified obligation
- You are a U.S. person who during the current year received either:
a. More than $100,000 from a nonresident alien individual or a foreign estate that you treated as a gift or a bequest. If you fail to report this gift on a 3520, the penalty is five percent per month of the amount up to 25 percent. Furthermore, if the 3520 is not filed in a timely manner, it is at the IRS’ discretion to determine how the gift is categorized. The IRS could decide the gift is taxable income and issue a Notice of Deficiency to the taxpayer.
b. More than $15,102 from a foreign corporation or partnership that you treated as a gift.
It should be noted that if you are required to file Form 3520, it is due on the same date as your income tax return, but it gets sent to a different address and not is included with your 1040 income tax filing.
Foreign Trusts and U.S. Tax Liability
Trusts are defined in the U.S. Treasury regulations as an “arrangement created either by a will or by an inter vivos declaration whereby trustees take title to property for the purpose of protecting or conserving it for the beneficiaries under the ordinary rules applied in chancery or probate courts.” The law looks into whether the entity acts like a trust, regardless if it is named a trust. It is also important to note that business or commercial “trusts” are not classified as trusts under the code.
Foreign trusts can run into U.S. tax issues. First, we look at whether the trust is a foreign grantor or non-grantor trust. A grantor trust is still controlled by the grantor (the creator) of the trust; a non-grantor trust is no longer controlled by the grantor/creator. A grantor trust’s income is taxable to the creator. A non-grantor trust is taxable where its income is sourced. Only income sourced in the U.S. for such trusts is federal taxable.
However, if there is a U.S. beneficiary, there is a “throwback” rule, which traces back for the accumulation distributions of U.S. beneficiaries from the non-grantor trust. This means that when a foreign non-grantor trust has United States beneficiaries and accumulates income, distributions in excess of current year income amounts carry tax liabilities.
If you are the beneficiary of a foreign trust, it definitely would help to consult with a tax attorney. We can assist in identifying the trust, what you are exposed to in terms of taxes, and what you need to properly file to stay in compliance. We stand ready to help.
Foreign Trusts Reporting Requirements
If you own a foreign trust or inherit one, you will need to fill out a Form 3250-A. This form needs to be filed by March 15th each year. An automatic six-month extension may be granted if requested by filing a Form 7004. Sometimes you may be required to fill out a Form 3520 to report transactions or new ownership of a trust due to inheritance.
If you file a substitute Form 3520-A with your Form 3520, then the Form 3520-A is due by the due date of the Form 3520, which is the regular tax filing deadline of April 15th. You should identify your foreign trust by EID (Employer Identification Number; if it does not have one you must applyfor one.
If you have a foreign trust that meets grantor trust rules, it must be reported on Form 3520-A. Failure to report incurs a $10,000 penalty or five percent of the gross value of the portion received, whichever is greater. A continuation penalty of $10,000 may be imposed for every month of delinquency, up to a maximum of $50,000. See I.R.C. § 6677. The penalties are imposed upon the U.S. owners rather than the foreign trusts. Id.
Form 3520-A is due by March 15, not April 15, like most tax forms. If you need to file an extension to file your 3520, use Form 7004. Form 3520, on the other hand, is due on April 15. See Instructions for Form 3520. However, those who are on military or naval duty outside of the U.S. and Puerto Rico have a deadline of June 2015.
The same is true for any individuals who live and have their place of business or post of duty outside of the U.S. and Puerto Rico. Pay close attention to these dates. Many tax preparers are not aware of the earlier filing date, and thus, submit Form 3520 late.
Additionally, the IRS requires that taxpayers file Form 8082, Notice of Inconsistent Treatment or Administrative Adjustment Request (AAR), if they are treating any of the trust items differently for tax purposes on their returns than they were treated on the trust’s returns. See Instructions for Form 8082
There are limitations to the persons and circumstances in which this form may be filed that are important to review for anyone who believes they must file this form.
Form 8082 should be filed with your tax return. Failure to file can result in interest and penalties.
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Inheriting Foreign Assets and Your Taxes
A situation we have often seen is when someone inherits or receives a gift from a foreign national. This situation often brings about a good amount of confusion, but this is something our firm can work with to ensure you are in compliance as well as properly accepting gifts.
Federal gift and inheritance rules apply to gifts given by U.S. citizens and permanent residents who are domiciled in the country, regardless of where the physical gift may be located. (cite) Therefore, if you receive a foreign asset from an American citizen, the gift taxes will apply as they would for a gift of a domestic asset.
Gifts made by a foreign national are not subject to federal gift taxes unless the gift is situated in the U.S. (cite) Treaties between the U.S. and various nations govern this area as well. You can see the IRS’s list of such here.
However, as a U.S. taxpayer, you are taxed on your worldwide income. Thus any income gained from a foreign asset gifted to you will still count for income tax purposes.
As for inheriting a foreign asset, a similar structure applies as to gifts. If the person who bequests you a gift via inheritance is not a U.S. citizen or permanent resident, there is no estate tax impact. Further, there is no estate tax on inheritances of foreign assets then brought into the U.S. (think cash).
However, the income from the assets you now own will be part of your total income for income tax purposes, even if a foregin business entity. In addition, there might be some other reporting rules that may apply to the asset that we can assist you with since you now own a foreign asset.
Conclusion
When filing your taxes, it is important to include information about all sources of income, which can include a foreign trust or a bequest or gift from a foreign source. You will need to file Form 3520 with your 1040. If you fail to do so, you can be hit with penalties and interest. Nobody wants that to happen.
It is best to be proactive when dealing with tax issues, especially if they are associated with income from outside the U.S. That is why I urge clients to consult with me when it is time to prepare their taxes. We can talk about which forms need to be completed and answer any questions they may have. I invite you to do the same.
